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New highs beget new highs

Some people believe we are in a “melt-up.” It is where the simple weight of money pouring into the U.S. stock market continues to carry stocks ever higher. Whether that qualifies as an investment thesis, or simply a lame excuse to justify record highs, it matters little to the bulls.

It is true that this past week, we actually witnessed a rare event—a two-day, 50-point drop in the S&P 500 Index—before stocks recovered. But good news on Friday morning (job gains in the economy came in at 236,000) cheered investors. It was largely a goldilocks report where wage gains (considered inflationary) were flat for the month, bringing the the average hourly earnings rate up to 3.2% year-over-year.

Overall, the official U.S. unemployment rate is now 3.6%, which is the lowest level since 1969. It brings the total number of monthly job gains to 103 in a row, which has never happened before. Given that it is also the best start in the year for stocks since 1987, is there any wonder that exuberance is the prevailing mood on Wall Street (and in the White House)?

Even the bears, whose numbers are expanding by the way, admit that if we did suffer a correction, it would be, at most, shallow and sharp. That’s the kind of correction you want, if and when it occurs. I have been reporting faithfully each week the bullish rise in investor sentiment and, although it remains flattish at 55.7% bulls, it is still quite high.

Earnings season, which is 80% complete, turned out to be better than expected in the minds of most investors. And although the Fed did not cut interest rates this week at their FOMC meeting, I have to wonder if anyone really expected that to occur?

As we move into spring, it appears that the wall of worry we have been climbing is crumbling. We should finally receive a verdict on the U.S./China trade agreement as soon as next week, according to administration officials. Talks in China last week went well, and the Chinese delegation will be back in Washington this coming week to hammer out more details.

Some argue that a successful conclusion to this issue, which has been over-hanging the markets for almost two years, is largely discounted. Could we get a “sell on the news” reaction if a deal is announced?

We could, but I think it would depend on the level of the markets at the time. If, for example, the S&P 500 Index were to be trading above 3,000 or so, (another 70 points higher from here), then yes, it could be an excuse for some profit-taking.

And while everything seems rosy for the economy overall, we don’t want it to get too much stronger in the short term. Remember, the Fed is data dependent. If, for example, the central bank did cut rates by a percentage point, as the president asks, in order to goose the economy, you can bet the next move by the Fed would be to reverse that and hike rates.

I believe the Fed’s about face in interest rate policy last December is the real reason the market is where it is. If investors believed that the Fed’s easy money policy might change, the markets would plummet. The Chinese economy might also be a factor.

In case you haven’t realized this yet, China, as the world’s second largest economy, has a substantial impact on overall global growth, including growth and inflation within the United States. Recently Chinese authorities have relied on fiscal spending to support their slowing economy, which has been hurt by the tariff issues.

A trade deal would be as good for China as it would be for the U.S. It could boost growth in both economies. But what’s good for economies is not always good for stock markets. Rapid growth, on top of moderate growth, might ignite inflation.

In the past, Chinese demand for raw materials to fuel their growing economy has sparked inflation globally. If that were to happen again, it could force the Fed to reverse policy, raise rates, and cause a repeat of last year’s sell-off. While this scenario is only one among several possibilities, it is something to keep in mind, given that we are within a week or two of a potential compromise solution in the trade talks.

The economy powers ahead

The first print of the nation’s Gross Domestic Product for the first quarter of the year came in at 3.2%, versus 2.5% expected. That was a big beat and justifies the market’s gains over the last three months.

If you couple this with the quarter’s earnings results, which have been stronger than expected, you have the ingredients for a goldilocks economy and strong stock market.

“If the numbers were so good,” asked a client, “then why didn’t the markets react more positively to the news?

Well, one reason may be that the data provided a past view of the economy and financial market usually look at (and discount) future expectations. But the numbers do have some value. For example, it should put to rest the worries that a recession is just around the corner. Remember all the anxiety the inverted yield curve created just a few short weeks ago? As I advised at the time, ignore it, because even if it did predict a recession, it would be 1-2 years into the future.

Another issue is the historical levels that the markets have achieved this week. As I predicted, the S&P 500 Index hit and surpassed its all-time closing high. NASDAQ did as well. Usually, when milestones such as these are achieved, markets at least pause, if not pull back, before trying to achieve further gains.

So, while GDP was a blow out number, the markets had already discounted it. What then, would markets need to see in order to forge through the old highs?

A trade deal between the U.S. and China would help. That wish may come true sometime next month. An agreement would be good for both countries. The Chinese market has been one of the best performing markets in the world so far this year. Although expectations of a trade deal have fueled part of the Chinese equity rally, the government’s monetary and fiscal stimulus program (implemented this year to boost their slowing economy) is the real reason for those gains.

However, comments by some of China’s economic ministers have recently cast doubt on how much more stimulus investors can expect. As a result, stocks have tumbled by almost five percent over the last few days. This Chinese market action could give us a hint of what we can expect at some point in our own markets.

We are clearly in need of our own pullback, if only to provide a pause, a decline, which would push down prices, give investors a new reason to buy, and energize participants to assault new highs on all the averages in the months to come. It could be precipitated by anything—higher oil prices, a hawkish statement by the Fed, a wrinkle in the trade negotiations.

Exactly when this expected pullback will occur is anyone’s guess. Traders have been burnt over and over again trying to time this event. Every time they short the markets, however, buyers swoop in and push prices back up through the trendline.

As readers know, I have been watching various measures that might give me some advanced warning of a decline. While investor sentiment is clearly a cautionary sign, this week, the price action in the small cap and semiconductor sectors seem to be signaling some additional bearish sentiment.

Semiconductors have led the technology and the stock markets higher for well over two years. This week they made what is called an” island top,” a new blow-off high which, after a few days, reverses downward hard. That occurred on Friday after Intel, a semiconductor bell weather announced poor earnings results. It pulled the NASDAQ index down with it, despite positive results from Microsoft and Amazon.

Small cap stocks, which normally lead markets higher as well, have lagged the indices and, despite repeated attempts, still are nowhere near their old highs. That said, I still think the risk is being out of the market, rather than in it. Stay invested but be prepared for the pullback

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About Bill

Bill Schmick was born in a blue-collar neighborhood of Philadelphia, just a few blocks north of “Rocky Balboa” territory where most of his Catholic schoolmates grew up to be either cops or criminals. He narrowly escaped both professions by volunteering to fight in Vietnam as a U.S. Marine... Read More

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